The investment opportunity: 38 million pizza-starved Poles

“The joy of pizza is that bread, sauce and cheese works fundamentally everywhere.” Domino’s Pizza CEO J Patrick Doyle has a simple explanation for his company’s success.

There are pizza places in many towns around the world, but not many have had as much success as Domino’s Pizza. And Domino’s success isn’t just about bread and cheese. Domino’s sold 61 million pizzas in Britain last year, because of its franchise business model.

Essentially, Domino’s uses other people’s capital to grow its business. In return for using the brand, the franchisee pays a royalty to Domino’s on his sales. When he starts up, he invests his own capital in opening a store. And on a daily basis he also buys his raw materials, pizza boxes and the rest from Domino’s. In return, he has the support of the brand behind him.

It’s a good arrangement. Domino’s gets royalties from franchisees, and in exchange, it maintains a strong brand. As the store system grows, so the advertising pot gets bigger and there is a virtuous circle.

The business has delivered for investors as well as customers. The shares were floated on Aim in late 1999 at the height of the bull market. They drifted down for a year before bottoming at 10p. Last year’s high was £7 and there have been plenty of dividends to add to that capital gain.

The franchise model has worked here in the UK, so why not in Poland? DP Poland listed on Aim in 2010 as the owner of the rights to Domino’s in that country of almost 40 million potential pizza-eaters. It has a great product and the business model has been successful before. Can it repeat the trick?

Royalties in, advertising spending out

Domino’s is one of those rare companies that’s achieved strong growth, while at the same time throwing off cash, in the form of dividends and share buybacks. The secret ingredient is the franchise model.

Domino’s owns very few of its stores, the vast majority are run by franchisees. But the company doesn’t simply sit back and watch the franchise royalties roll in. It has to hold up its end of the bargain. The big cost is the advertising and marketing support that Dominos provides centrally.

In the UK, this has included expensive sponsorship of The Simpsons on TV to raise general brand awareness in addition to more focused support such as developing smartphone apps for ordering.

To work, this plan needs scale

It’s easy to see the appeal of the Polish market after Domino’s great success in the UK. The founders of DPP also have experience in developing consumer food outlets in Poland. They rolled out the Aim-listed Coffeeheaven chain in Poland, which was ultimately bought out by Costa Coffee.

Unfortunately, it hasn’t worked out as hoped. The shares rose to over 100p in the first months after the initial public offering (IPO), but after further fund raisings, they currently trade around 15p. What’s gone wrong?

There’s a minimum efficient scale needed before you get the accelerating profits and cash generation that Domino’s UK has enjoyed. This takes time and effort to achieve – bear in mind the UK business was trading for over a dozen years before it floated.

Once you do get the system beyond a certain size, you cover central costs and are able to spend increasing amounts on advertising the brand. This makes you an attractive proposition to potential franchisees looking to start a business.

DPP was a start-up with overly ambitious targets. Selling Domino’s pizzas is also harder in an economy where the brand isn’t well-known, and where people have less discretionary spending than the UK and less of a convenience food habit. In time, Poland will catch up.

This can work – but it needs time

The stores’ original break-even target of six months has been adjusted to 18 months. Store maturity is now seen as taking three years. Even then, profits will only be about half the level of a good UK outlet. The store format has been improved and the first franchised store has now opened.

It looks like the emphasis will be on proving this format over the next year or so before expanding the chain. The board has been significantly strengthened with Chris Moore coming on as a non-exec. He was CEO of Domino’s UK, so his experience should be invaluable. He’s also been joined by Gerry Ford, chairman of the Caffè Nero chain.

The bottom line is that it’s going to take time. Early investors no doubt looked greedily at the UK profits and didn’t think hard enough about the scale of the challenges. The UK business itself had plenty of growing pains before it became a cash machine. So DPP is one to keep on the watch list. But it’s also one that needs some patience.

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